We used to have fun commenting about the bond market, including Treasuries, Mortgages, Municipals, and Corporates. But that was before the dark times. Before deleveraging.
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Thursday, April 30, 2009

Its flying a little under the radar this morning, but the Fed just disavowed the market of the notion that they would defend the 10-year at 3%. Today's Permanent Open Market action was to buy a paltry $3 billion in 10-year and longer notes.

Here are the last several POMOs of Treasury bonds (excluding TIPs)

I color coded it by the portion of the yield curve which the Fed was buying at each action. Notice that its very clear that the Fed isn't doesn't have a soft target of 3% on the 10-year. Moreover, the Fed isn't focused on the 10-year portion of the curve at all. Most of the buyer has occurred in the 4-7 year area, which I'm assuming the Fed thinks will be most influential on consumer borrowing rates.

This leaves me tactically short the 10 and longer part of the curve, looking to re-enter (I'm still a deflation believer) at a higher yield level. Technically, I don't see any stop points between 3.07% and 3.80%, so I'll probably we waiting a bit before re-entering the long-term Treasury market.

Consider how the major home price indices, both the FHFA and Case-Shiller, use repeat sales to calculate home price changes. Basically they look for homes that have sold twice, and measure the price change between the two sales periods. So if a home sells to the Skywalker family in 2004 for $100,000 and then to the Organa-Solo family in 2007 for $115,000, we'd call that one data point indicating that homes rose by 15% over those three years. (Do we think that Amidala's house was foreclosed on after she died? Or was there family money there?) Combine this with millions of other data points, and you can get some pretty solid estimates.

Now, I don't know of any better way to measure home price changes. Certainly I don't like using appraised values, especially in a market like this one. But the paired sales method is bound to lag reality in a market like this one.

Consider what we have in housing. Too many houses were built, and too many borrowers got funding that shouldn't. The former means there is too large a supply of homes, and the later means that foreclosures are creating even more supply of homes!

We in the financial business are used to things moving fast, but the housing market doesn't work like that. The foreclosure process is slow, and given the ever-changing world of government programs, I think many banks have been especially slow to initiate foreclosures. On top of that you have loan mods, a large percentage of which will re-default. For these reasons and others, I'm sure we will still be dealing with large numbers of foreclosures a year from now.

And remember that foreclosures aren't going to be evenly distributed across the country. They will be focused in areas where the bubble was worst. In other words, areas where there was already too much supply from builders! Areas where the gap between supply and demand is widest.

Demand for housing is also quite inelastic. I already have a home. Lower prices in and of itself doesn't incent me to buy another house, because I'd have to sell the one I have anyway. It isn't like when the Gap needs to clear out excess sweater inventory. They can make everything half off and unload it all. America needs to do a half-off homes sale, but can't actually get anyone to come to the mall to buy.

So it is inevitable that as actual transactions start to pick up, those transactions will show lower and lower prices, especially where foreclosures are high. Even when the housing situation stops getting worse, statistically, prices will keep falling. But we can't get to a bottom unless transactions pick up (which they have), and inventories are cleared out. The fact that increased transactions largely represent increased foreclosures is neither here nor there. We know foreclosures are coming. Let's get them out of the way.

Put all this together, and I'm watching stats like Existing Home Sales and NAHB confidence survey much more closely than today's Case-Shiller Index. On that basis, its reasonable to see the decline in housing finally abating. But only a fool would say that prices are about to bottom.

Thursday, April 23, 2009

One of AI's long-time readers has started a new Bond Trader Forum, which I'd really love to see take off. Most investment forums are filled with amateurish comments and people pumping their own positions. It would be great to get something really professional going...

You may be asking yourself, what the hell are these BABS every one is talking about? Is Barbara Streisand trying to pull a redux of the old Bowie Bonds? No! Its even stranger than that!

As you know, municipal debt is usually tax exempt (not always, as is commonly misunderstood). Thus the IRS collects nothing on whatever interest income individuals realize out of municipal bonds. Since its mostly the wealthy who buy munis, that's about 35% in taxes not collected.

But here is the problem, individuals can only buy so many bonds. For most of the last 10 years or so, any excess supply from municipalities was soaked up by TOBs. Now those programs are all but extinct, and individuals can't take up the slack.

The Federal government has put forth "Build America Bonds" (BABs) as an alternative. See, while individuals aren't buying enough bonds, pension funds, money managers, and even sovereign wealth funds are dying for long-term bonds that let them sleep at night. Currently there isn't much in the corporate bond world that fits that bill. State and local governments are much safer. As I've written before, a municipal default has very little in common with a corporate default, so even if we assume that municipalities will suffer through more stress than any time since the Depression, its still a relatively safe market.

The Treasury gives the municipality a 35% rebate on the interest cost of a BAB. So if the municipality issues bonds at 6% with, the Treasury will rebate the municipality 2.1%. This allows non-tax paying institutions to buy the municipal debt with taxable-type yields.

Buying in BABs has been extremely aggressive. We saw the New Jersey Turnpike issue bonds maturing in 2040. They were issued at $100 on 4/20, traded as high as $106 that same day! Of course, California's huge $6.8 billion deal stole the thunder. I myself tried to buy $6 million and got zero. Meaning the bond was in such hot demand, they didn't give me a single bond. Either that or its J.P. Morgan (who underwrote the deal) giving me a giant middle finger. Right back at you Dimon...

Anyway, these bonds aren't for you. Don't buy them in the secondary. Its fine if you are a pension fund or some other entity with long-dated liabilities. In fact, I think these bonds are perfect in those circumstances. But for every one else, stick with more liquid intermediate-term securities. I've been trading taxable municipal bonds my entire career, and trust me when I say the liquidity isn't there. So these bonds have to be mostly buy and hold bonds. Which is fine, but do you want to be buy and hold for the next 30 years?

By the way, the reason why BABs are currently only long-term bonds is because that's where the municipal yield curve is widest vs. the Treasury curve. In shorter bonds (say inside of 20-years) a classic municipal bond issue makes more sense for the issuer.

Monday, April 13, 2009

Regular reader and sometimes commenter Gingcorp asked me to comment on this article in the New York Times about some, shall we say, questionable practices at Morgan Keegan's muni department.

I happen to know a fair amount about the problem of swapped muni VRDB's as I had a two clients threatened by similar circumstances. Unfortunately, the NYT article makes it sound like the municipalities were betting on interest rates which simply isn't the case. So I feel compelled to tell the world what's really going on here. Bear in mind that I can't speak to the situation in Tennessee specifically, because every situation can be a little different, but this should give you the general picture.

First, let's say its five years ago and you are one of these poor unsuspecting municipal authorities. Let's assume you are the authority who manages the local airport, the Bumpkin Airport Authority. You'd like to issue debt, and like any responsible financial steward, you want to minimize your interest cost.

Your banker suggests that a variable rate bond would lower your expected interest cost, because demand for short-term bonds is extremely strong. In 2004, the typical rate on variable rate muni debt (either auction rate or VRDN) was around 1.5%. (There are some additional fees involved, which we'll get to in a minute.)

First, a quick lesson on muni variable rate bonds. In a VRDN, the investor has the option to "put" the bond back to the municipality on any interest rate reset date, usually every 7 days, at par value. With an auction rate, investors can choose to "sell" at any auction, assuming the auction doesn't fail. Remember that until 2007, auctions almost never failed, so this wasn't seen as a big risk.

In both cases, the interest rate isn't based on some reference index, like LIBOR, but whatever interest rate clears the market.

But you, as the municipal airport authority, aren't interested in taking variable interest rate risk, as you don't have any natural variable rate assets. You'd rather lock in a certain interest rate today and have a known cost for whatever you are selling the debt to construct.

Your friendly banker has a solution. Sell the debt variable rate, and at the same time enter into a pay fixed, received floating swap. On its face, this can hardly be called creative finance. Its really finance 101. You have a floating liability, you want a fixed liability, just enter into a swap. Simple.

The Sith Lord was in the details. First of all, in order to do a VRDN, you needed to get a letter of credit from a bank. See, investors needed to know that the municipality had the cash to fund that put option I described above. The bank LOC allowed for that. So let's say the bank was charging 0.25% for the LOC. In the case of an airport authority, the bank would probably require that the municipality also buy a monoline insurance (e.g. Ambac) policy to protect the bank in the event the municipality defaults and the bank gets hit with a wave of puts. Let's say that costs about 0.10%.

But even in the face of those extra fees, the issue floating/swap to fixed still saves you a lot of money, because the fixed side of the swap is actually below where you could sell fixed rate debt. Everything is peachy.

The only remaining hitch is that, as I said above, muni VRDNs don't reset based on a specific index, but on whatever rate clears the market. This left the possibility that issuer A might pay a slightly higher rater than issuer B one week, but then issuer B would be higher the next week. Not because of anything about the issuers themselves, but just because of random variations in supply and demand at any point in time.

Unfortunately, the floating side of the swap had to be based on some predetermined index. Bankers usually picked one of two options. Either the SIFMA index, which is a published index of muni VRDN rates. Or they used 67% of LIBOR. E.g., if 1-week LIBOR was 3%, the the swap rate would be 2%. The 67% number was intended to reflect the typical gap between taxable and tax-exempt money market instruments. I believe the LIBOR version was more popular than the SIFMA version, and I have also heard swaps struck at 80% of LIBOR.

Right there was the red flag. What happens if the VRDN rate set by market forces isn't equal to the 67% of LIBOR level? This is known as basis risk, and it did happen under normal times. But it was always short lived. For example VRDN rates always rose during times when retail investors were pulling money out of muni money market funds, such as tax time. But those periods of elevated rates was always short-lived. The huge savings from the synthetic fixed rate structure overwhelmed these short-term costs.

Let's go back to the bank providing the LOC. Remember they required you to have a monoline insurance policy from Ambac to protect themselves. The actual legal language probably says something to the effect of...

"ABC Bank requires that Bumpkin Airport Authority acquire an insurance policy from a monoline insurer rated in the top ratings category from Standard & Poors and Moody's Investor Service. Should the authority be unable to acquire such a policy or should the monoline insurer be downgraded below Baa3/BBB- ABC Bank may withdraw the letter of credit."

Of course, don't need to worry about Ambac being downgraded right? Er... From the investor's perspective, you didn't wait around for Ambac to actually be downgraded. You were allowed to put these bonds back to the issuer at par! You hit that bid as hard as you could as fast as you could.

So now what happens? Remember that the interest rate that the Bumpkin Airport Authority actually pays is set by supply and demand. Now that the LOC is threatened, there is no demand, all supply. In order to actually entice some buyers, they had to set the rate at 7%, 8%, 9%, etc. Note that these weren't the failing auction rate bonds we heard so much about, although a similar story would apply have Bumpkin decided to go ARS.

Now Bumpkin is paying 9% on their VRDN, while the floating end of the swap is only paying you 67% of LIBOR, currently a glorious 0.25%. On top of the 9% you are paying investors, you are also paying your swap provider whatever the fixed leg of the swap is, probably something in the 4% area. Ugly.

But wait... it get worse. The interest rates are actually set by some dealer, called the remarketing agent. In normal times, the dealers would set the rate at something reasonable, and if they couldn't sell all their bonds right away, they'd just inventory them. So if it happened to be that a big holder of the Bumpkin Airport bonds wanted to put their bonds back on a given day, it was no big deal. The investment bank was willing to just hold the bonds waiting for the right investor to come along. It was considered a good use of balance sheet because it justified the remarketing fees the bank was collecting.

Once dealer balance sheets became crunched, nicities like this went right out the window. Instead of holding the unsold inventory, the dealers were exercising their rights to push bonds they couldn't remarket back to the LOC bank. These then because so-called bank bonds, and Bumpkin was charged some pre-determined rate on these, I think it was set off Prime.

But wait... it gets worse. Remember that the swap was intended to be a hedge against rising interest rates. It is therefore effectively a short position on long-term fixed rate bonds. In fact, long-term bonds have skyrocketed in value. Thus your swap is getting crushed. A 30-year swap struck on January 1, 2008 for $10 million notional value would currently be down $3 million in market value. Put another way, if you want out of this swap, you need to pay the investment bank $3 million.

Had the swap remained an effective hedge, this wouldn't be a problem, because Bumpkin Airport would be saving an equivalent amount of money on plummeting short-term rates. But in fact, Bumpkin is paying a usurious 9%.

What most municipalities did was refinance the Ambac-backed deal with a new VRDN without that stipulation. Except for a brief period in September and October 2008, the VRDN market has been pretty healthy. So once you refinance the VRDN, then the swap goes back to being a decent hedge. Everything works out just fine.

But even if you do a new VRDN deal, you still need a LOC from a bank. Guess what? Banks aren't so keen on tieing up their capital to make 25bps on muni LOCs. Instead, they've been picking carefully who they deal with, and charging a lot more to do it.

Even if the municipality can restructure, it isn't out of the woods entirely. If the swap is deeply underwater in nominal market value, the municipality probably has to post additional collateral. Think of it similar to margin posting on a futures contract. In some cases, this is no big deal, because the municipality has a decent sized general fund and simply must set aside certain securities as collateral. But in other cases, the municipality has little safety net. In fact, its more likely an issuer like Bumpkin Airport Authority has a sizeable investment portfolio compared with some county or school district which collects taxes directly. A lot of times, issuers with full taxing authority keep less in general funds. Politically, if the voters see that their county has a big investment balance they start wondering why tax rates aren't being lowered and/or why the money isn't being spent on new projects. An issuer with more volatile revenue, like a airport, toll road, hospital, etc., is more likely to build a reserve. It tends to be less politically sensitive if there aren't any direct taxes involved.

If you are an investor in munis, the best thing to do is hunt down how much VRDN exposure your bond issuers have, whether they have any monoline contracts attached, and what their plan for dealing with both is. You will probably find that you have nothing to worry about, but if you are sloppy, you could wind up with the next Jefferson County.

Wednesday, April 08, 2009

This is the second time I've made an Anoat allusion in a week. That has to be a record of some kind.

Anyway, how worried should we be about the lack-lustre start to the TALF? The thing that really worries me long-term is that we fall into a deflationary spiral, which really would result in Great Depression: Episode II. As you can see in this graph...

... bank reserves have sky-rocketed. Meaning that while the Fed has been busy "crediting bank reserves (i.e. printing money) to pay for their programs, banks have been shoving that money under the proverbial mattress.

The so-called shadow banking system is even worse. The ABS market has completely collapsed (at least until the TALF, more on that coming). Thus all spigots to consumer credit have slowed to a trickle. That has serious implications for the de facto money supply, which by my estimation is sharply negative.

TALF aims to reverse that. We might not be able to force banks to lend, and maybe we really want them to rebuild capital anyway. And we do want consumers to save and rebuild their own balance sheets. But we also don't want them to over-save. That's how we become Japan. But if we get a decent new issue ABS market doing, then at least consumers who can afford credit can access credit.

The TALF was supposed to work by basically giving a tax-payer subsidized free lunch. A nearly guaranteed arbitrage. But in fact, no one is showing up at the Fed to take out TALF loans.

Its worrisome, but we shouldn't panic yet. First, we don't really care how much the Fed lends under the TALF program. We actually only care that the ABS market gets back on its feet. So far, we've only had very high quality ABS deals get done since the TALF: a couple auto loan deals, a couple credit card deals, and a student loan deal back by the Department of Education.

ABS traders I've talked to say there is plenty of demand for those deals, but for whatever reason it isn't TALF demand. Its possible that buyers have other funding options away from the TALF. Amidst worries about Congressional interference in compensation and other BS, I'd sure as hell take some other funding option even if it were at a higher cost. The ability to bring back my girlfriend from the dead just isn't worth making a deal with Darth Pelosi.

There is also supposedly strong secondary demand for ABS, which is stuff that wouldn't be TALF eligible anyway. Its almost like a market that's properly functioning! People are looking for good bonds at decent spreads!

Anyway, its possible that the TALF actually revives the market without being used heavily. This is basically what happened with the Fed's commercial paper program. It revived that market at least to the point where the top issuers can access the market.

So the thing to watch is not TALF loans, which I'm sure is what the media will focus on. Watch ABS issuance.

Monday, April 06, 2009

Every one wants to blame the financial crisis on leverage. There was a glib comment on the blog the other day which reflects a common view:

"Sad to see the "cure" for overleveraged, undercollateralized balance sheets to be... more leveraged finance."

No offense to Jonathan intended, as his view probably reflects the majority of opinions among those who follow finance. But I find blaming leverage per se to be a weak argument. Thus I don't see bringing some degree of leverage back into the market as a negative. Furthermore, I don't think that simply blaming leverage will be constructive as we try to construct a regulatory structure to prevent similar meltdowns in the future.

Let's consider the case of a CDO of ABS. To make life simple, we'll assume CDO was constructed from mezzanine bonds from HEL deals. This would be securities similar to the ABX 2007-1 A index, basically the segment of major home equity deals from early 2007 which were originally rated "A."

The HEL deals were structured something like the following (although I'm presenting a simplistic version, the point stands.) I'm assuming $100 million original face, with the underlying mortgages having a 6.75% rate.

Senior: 5.75% coupon, $80 million

Mezzanine: 6.50% coupon, $15 million

Subordinate: 8.00% coupon, $5 million

All principal cash flows to the Senior until it is entirely repaid, then to the Mezz, then to the Subs. Interest payments are only made to the mezz and subs if the senior interest obligations have been met. (Don't get hung up on the math right now, it won't be important to my point. If you have questions about ABS and/or CDOs, e-mail me. Accruedint AT gmail.com).

In a CDO of ABS transaction, the CDO would buy a series of mezz bonds, then repackage them into a similar senior/sub structure. So now let's say we have a $100 million CDO which buys the mezz of 50 different HEL deals, all structured similarly to above.

The CDO builds its own senior/sub structure as follows:

Senior: 5.45% coupon, $80 million

Mezz: 6.00% coupon, $12 million

Sub: 8.00% coupon, $4 million

Equity: $4 million

Same deal as above, where the senior gets all principal and interest due before the other pieces. Only once all other classes get their principal and interest does any cash flow accrue to the Equity. One might think of the sub/mezz/senior pieces of the CDO as providing leverage to the Equity. Since the total assets in this deal is $100 million, with equity of $4 million, we have 25x leverage.

Its easy to see why the CDO of ABS world came crashing down. The ABX 2007-1 A is now trading at $2.5, or a 97.5% loss vs. the original face. So the CDO built on securities similar to ABX would have almost all principal in the deal wiped out entirely. Even the senior most piece of the CDO, which would have been rated AAA originally, would have suffered huge losses.

But was it the 25x leverage that was the problem? Not at all. Substitute any number for the equity, and the structure still doesn't work, because the underlying collateral is crap. If you are going to try to tell me that leverage caused the meltdown, then you'd need to show me how a different leverage figure would have prevented the problem. Here is an example of a leveraged vehicle that fails at any haircut.

Now one might say that if the ratings agencies would have required more overcollateralization, these CDOs never would have been created. Perhaps. But again, if leverage isn't the problem with the security, then allowing too much leverage wasn't the ratings agencies' primary mistake. The real problem is that the ratings agencies never considered the binary nature of these structures. If you build a CDO based on all mezz consumer loan ABS, and consumer loans perform poorly, then the whole deal is threatened. We didn't need catastrophic losses on consumer loans to impair the senior-most pieces of these CDOs. Had sub-prime consumer loans suffered a mere 10% loss rate, the CDO would have suffered a 50% loss rate! That would have resulted in the "AAA" rated Senior piece suffering a 30% loss. That isn't acceptable for a AAA-rated asset.

It isn't like the ratings agencies should have rated these types of CDOs AAA at some lower leverage level. They shouldn't have rated these types of CDOs at all. We talk about toxic legacy assets. These CDOs were toxic from the word go.

Now consider this. Why didn't the ratings agencies figure that consumer loans could go all go sour at once. Why did they assume that a 10% loss rate was nearly impossible? Or if you want to damn the ratings agencies as mere minions of the investment banks, why were people buying these CDOs? Those investors must also have assumed that the 10% loss rate was nearly impossible. Else they wouldn't have bought the bonds at all. So why was every one so confident?

We all want to blame some nefarious party, because that would feel better. It is more satisfying to think we were all duped by the evil geniuses on Wall Street. But what if it was as simple as the Fed having succeeded in dampening the business cycle that people started to assume volatility would remain permanently low? What if the fact that previous disturbances that could have had greater contagion (1987 crash, Asian Currency crisis, Russian Debt crisis, LTCM, Y2K, Dot Com bubble, 9/11, etc), didn't. People began to assume the age of crashes was over.

Now I'd be a fool to say that leverage played no part in the crisis. Clearly financials got over-leveraged. Part of the problem is that with so much leverage, some financials (AIG, Lehman, Bear) didn't have enough time to see if their asset bets would play out. But why they got over-levered was a response to contracting yield spreads. Or put another way, ROA was dropping so in order to get the same ROE you needed more leverage. Spreads were contracting (and thus ROA falling) because there was greater confidence in a more stable economic horizon. As ROA fell, too many fell into a trap of buying poorly constructed securities to get a relatively small amount of extra yield. And before you try to say that no one saw ABS CDOs as riskier, consider that the senior-most ABS deals always yielded 20-30bps more than the senior-most commercial loan-backed CDOs. Every one knew that consumer ABS-backed CDOs were more risky!

So ultimately, leveraged investing comes down to picking good assets first, then getting the leverage right. The crisis has been brought on by poor asset decisions more so than too much leverage.

Thursday, April 02, 2009

I've written on mark-to-market many times. I've always felt it was a good concept but has been applied incorrectly. When the rules were written, it was never assumed that generalized risk aversion would ever rise to the extent that it has. Thus the rules assumed that a $30 decline in a bond price would always and every where indicate a security-specific problem. The rules (and/or the auditors) also assumed that securities that seemed similar at a glance could be used to value each other. They never assumed that various securities would ever become as granular as they eventually became. For example, a whole-loan RMBS with 15% California exposure suddenly was valued drastically differently than one with 25% CA exposure. But both were valued off the ABX as if they were the same, because the ABX was the only thing trading.

Anyway, the key thing that changes with this FASB guidance is the assumption of distress. Now any trade that occurs in an inactive market is presumed to be a distressed trade unless proven otherwise. I'd expect this means that most Level 3 asset prices will become more PV model-based and less trade based.

BUT...

I'd argue that this won't result in banks writing up their asset valuations. Think about it. Say XYZ Bank announces some huge quarterly EPS figure, but when the analysts look deeper into the number, it turns out it was all paper gains on Level 3 assets. Investors would universally pan the earnings figure, claiming it was all phantom profits on marks to make-believe valuations.

Conversely, let's say the same bank reports break-even earnings with no change in Level 3 and a healthy increase in loan loss reserves. Now what does the market think? Analysts would say that the bank has potential latent gains in their Level 3 portfolio that haven't been recognized.

This market is all about imagination. If you are a bank (or any financial), the market isn't going to just accept your balance sheet as reported. The market is going to try to imagine what your balance sheet is really. Since no one knows what it is really worth, investors are going to imagine. I argue that a bank is better off convincing the market that it is being too conservative, thus guiding the imagination to better times.

Otherwise the bank will only stimulate the imaginations of the "its all worthless" crowd, which I realize is the majority of the blogosphere. I don't get this point of view, and I think its all rooted in some sort of visceral desire to see the banking system crash and burn. I think Jim Cramer said it well on TheStreet.Com today:

"The first side is the "it doesn't matter and it is bad" camp. This is the camp that says it [the FASB ruling] is a mistake because it will give the banks too much latitude, and they don't deserve it. "Deserves," as they say in Unforgiven, "got nothing to do with it." This is a completely worthless position that makes you no money. Who the heck cares whether they "deserve" it? What is this, some sort of civics lesson? We are now going to invest on whether someone should be punished? This is about money. I could care less about "deserves". "

Its similar to my position on politics. As an investor you need to forget about what "ought" to happen and worry about what will happen. That's how you make money.

Wednesday, April 01, 2009

Apparantly my little blog has reached the galactic core. Investorfolio has added Accured Interest to their directory. I call upon both my loyal readers to follow this link and give a rave review. I call upon the hoards of readers who hate the blog to follow this link and give a scathing review.

-----UPDATE

So now Accrued Interest is #2 on Investorfolio's top hits list... and the blog I told you not to go to as a joke is #3... what is that telling you?

About Me

I oversee taxable bond trading for a small investment management firm. Opinions expressed on this website may not reflect the opinions of my employers. Strategies described here should not be taken as advice, and may not be the strategies being used for my clients. Take this website as the egotistical ramblings of a bond geek and nothing more. E-mail is accruedint *at* gmail.com or find on Facebook.